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Overview  Part I Thinking about the Uncertain Future  The need for a framework What are models? How to Use them Economy Wide and Global Economic Models  Key Features  Strengths and Weaknesses A peek inside a new generation of models (dynamic intertemporal general equilibrium models)

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Use of Models in Policy Evaluation  The world is an uncertain place  Models are useful for Forecasting Policy evaluation Scenario analysis

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Use of Scenarios  The most effective way to undertake scenario analysis is with an internally consistent and empirically relevant framework  We have developed a series of global economic models with many countries and many sectors based on new developments in intertemporal economics  The models form the analytical and empirical basis for designing alternative scenarios

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Use of Scenarios (1)  Ask the question What are the likely consequences of the Iraq War?  Design the scenarios that give different insights to the question Examine history (Gulf War I, Afghanistan, Vietnam, Korea)  Wars always cost more than expected  Costs are more than the fiscal outlays Shocks to  Government spending for the war (US,Aust,UK)  Government spending for the peace (Europe/Japan)  Increased global risk  Impose the shocks in a consistent framework (a model)  Interpret the results  Assess the key sensitivities that drive the results  Do people expect it to be temporary or more permanent?

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Scenario Examples  The Aftermath of the Sept 11 Terrorist Attacks  What if Japan Adopted a Sensible Macroeconomic Policy?  The Consequences of WorldCom and Enron Collapses  The War with Iraq: the compounding Effects of Oil Prices, Budgetary Costs and Uncertainty  The SARS Outbreak: How Bad can It Get?  Exploding Fiscal Deficits in the United States: Implication for the World Economy  What if China Revalues Its Currency  China: The Implications of Policy Tightening  Oil Price Scenarios and the Global Economy  The United States Current Account Deficit and World Markets  The Financial Effects of a Bird Flu Triggered Pandemic  Bursting of the US Housing Bubble

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What is an Empirical Economic Model?  A set of equations embodying the history of theoretical and empirical economic knowledge  Key bits identities behavioural equations exogenous inputs

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How to Use Economic Models  Very carefully!  Can get both quantitative estimates and new insights on complex issues

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What Features are Important in a Model?  Does the model explain anything we observe today or in the recent past (VALIDATION)? ;  Is the model continually reviewed by experts who actually use it; is it published in the refereed academic literature; is a full listing of all equations available on request; and is it generally open to evaluation by others?;

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What Features are Important in a Model?  Is the private market willing to purchase the model for the value it provides? ;  Do the model results pass the test of common sense?;  Are the mechanisms in the model transparent to other trained economists?

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Types of Economic Models  Input Output Models Trace the flow of resources between sectors; Little role for relative price changes or substitution of inputs or consumption bundles; Tend to be static; No allowance for capital accumulation or international financial flows; Ignore the role of money and asset prices;

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Types of Models  Old Style Macroeconometric Models Rely on correlations in time series data based on aggregate economic theory; Reasonably good for short term forecasting (tend to be quarterly) Difficult to understand results because of lack of theoretical structure; Unclear long run properties;

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Types of Models  Modern Macroeconometric Models More tightly specified theory Rational Expectations in some markets short run data consistency with long run theoretical properties tend to be quarterly

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Types of Models  Dynamic Intertemporal GE Models integrates the key features of the other types of models mix of econometric estimation and calibration annual frequency problem with large degree of dis-aggregation because of complexity of the numerical algorithms needs

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Types of Models  New Keynesian Models (also called Dynamic Stochastic General Equilibrium models (DSGE)) Since the publication of the Obstfeld and Rogoff textbook on International Economics, macro modellers have discovered intertemporal models  Sticky prices  Mix of optimizing and rule of thumb agents  Imperfect competition

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Overall model development strategy  Funding is both through research grants and private consulting  Hub and spoke approach to coordinating a global research project The model is managed/developed in the core research team in Australia and Texas Users (researchers/ governments/ financial investors) in different countries feed back to the core group both their own developments of the model as well as funding the core for new developments. All of which which we are able to incorporate into the model over time

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Development and Subscription Funding Major Funding  The Brookings Institution  United States Environmental Protection Agency  United States National Science Foundation  McKibbin Software Group Inc Minor Funding through consultancies  United Nations  Australian Dept of Environment  New Zealand Department of Commerce  Canadian Dept of Finance

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Key Features  the demand and supply side of the major economies are explicitly modelled ;  demand and supply equations are based on a combination of intertemporal optimizing behavior and liquidity constrained behavior;

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Households 2 types  A) maximize an intertemporal utility function consisting of all goods and services produced domestically and overseas, subject to an intertemporal budget constraint that the present value of consumption is bounded by the present value of after tax income from all sources  B)Base aggregate consumption expenditure on an optimal rule of thumb with current consumption of each good allocated so as to maximize contemporaneous utility

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Firms 2 types  A) Maximise their share market value (the present value of the future stream of dividends) subject to production technology, a cost of adjustment model of capital and taking prices as given. They base their calculation on a summary of the future measured by Tobin’s Q.  B)Base aggregate investment expenditure on a backward calculated Q  Apart from physical capital other factors of production are flexible – Labor, energy, materials, resources in GCUBED

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Governments  Governments provide public goods that enter into the utility functions on households (additively seperable) and transfer payments;  In MSG2 governments provide infrastructure that enters into the production function of firms with increasing returns

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Governments  Collect a wide variety of taxes on income of firms households, imports, sales.  Governments are subject to the intertemporal budget constraint that the present value of spending and transfers is bounded by the present value of future tax collections.

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Countries  Countries are collections of individual firms, households and governments that trade goods and services as well as financial assets;  Labor is immobile between countries but mobile within countries;  Financial capital is mobile within and between countries;  Physical capital is sector and country specific at any point in time and subject to adjustment costs over time.

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Role of Money  Money is required for transactions between all agents. There is a technology that combines money with produced goods and services and the combined product is what is available in the market.  The supply of money is determined by the a central bank in each economy via an interest rate rule in conjunction with assumptions about the exchange rate regime.

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Financial Markets  Financial markets exist for – Money – Government Bonds – Equity – Foreign Assets – Foreign Exchange  Each financial asset represents a claim over real resources – Money over purchasing power – Bonds are claims over future tax collections – Equity is a claim over the future dividend stream of a firm – Foreign assets are claims over the future exports of the debtor country

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Goods and Services Markets  Households, Firms and Governments trade goods and services and price for each is assumed to clear the markets at an annual frequency

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Factor Markets Labor Markets  Nominal wages are set by different institutional structures in each country;  Given the nominal wage and the market prices for goods and services firms higher labor until the real wage in each sector equals the marginal product of labor;  Aggregate unemployment can result although over time it is assumed that unemployment tends to force the nominal wage towards the labor market clearing level.

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Factor Markets Capital  once installed physical capital is costly to move;  Capital produces a flow of services for firms that have installed a capital stock through investment decisions in the past;  Investment is subject to rising marginal costs of installation and depreciation over time.

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Factor Markets Energy and Materials in GCUBED  Firms purchase the output of other sectors as inputs in production;  Total demand for the materials and energy sectors is final demand plus demand for intermediate inputs in each sector;  In contrast to standard CGE models (which assume Leontieff fixed coefficients between intermediate inputs and value added ) there is a CES production technology which allows substitution of capital, labor energy and materials in production.

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Based on the book: McKibbin W.J and P.J. Wilcoxen (2002) Climate Change Policy after Kyoto: A Blueprint for a Realistic Approach The Brookings Institution

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Overview  What is the climate change policy issue? Managing Uncertainty in a sustainable way  Features of a Sustainable System  What Has Been Done so far? The UN Framework Convention on Climate Change The Kyoto Protocol  Fatal Problems with the Kyoto Protocol?  An Alternative Approach: The McKibbin Wilcoxen Blueprint?  Where to go from here?

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 We need to distinguish between two separate questions: Should the world take action against the threat of climate change? Should the world implement the Kyoto Protocol?

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What is Climate policy about ? We know that carbon concentrations in the atmosphere have risen 30% since the industrial revolution. We know the science of the greenhouse effect. Uncertainty is everywhere : Uncertainty Uncertainty about link between carbon dioxide emissions and the timing and magnitude of climate change Uncertainty Uncertainty about costs and benefits of climate change Uncertainty Uncertainty about costs and benefits of abatement Uncertainty Uncertainty about the policy responses

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Some Illustrations of the uncertainties

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What should be done given uncertainty?  Some proposals: Do nothing Problem may be small, avoiding it may be expensive  (what if the problem is large and avoiding it is cheap?) Do something drastic Problem may be enormous, avoiding it may be cheap  (what if the problem is small and avoiding it is expensive?)  A prudent policy would avoid extremes Reduce emissions where possible at low cost

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Features of a Sustainable System Extensive - all major carbon emitters need to participate Implementable in key countries Equitable - across a range of dimensions Efficient - minimum economic cost Flexible - need to adjust as new information is revealed Low cost of implementation/administration Must establish clear property rights over a long period of time to provide the right incentives for all involved  households, industry, governments Should be in all participants interest to commit current and future participants within each country involved

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What has been Done so far?

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The UN Framework Convention on Climate Change  Negotiated at the Earth Summit in 1992 in Rio  Set Goals (not targets) “preventing dangerous anthropogenic interference with the Earth’s climate system” Annex I countries (industrial countries) were to adopt policies to “aim” to reduce their emissions Entered into force in March 1994  Set in process a series of meetings of the “Conference of the Parties” (COP)

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The Kyoto Protocol  Protocol to the 1992 UN framework Convention on Climate Change, negotiated at COP3 in 1997  Annex 1 countries agreed to reduce emissions of 6 greenhouse gases to 5.2% below 1990 levels on average between 2008 and 2012  No commitments for Developing Countries (countries such as China ratify but have no targets!)  Some flexibility allowed through permit trading clean development mechanism (CDM) joint implementation

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The Kyoto Protocol  legally binding when 55 countries accounting for 55% of developed country emissions ratify  USA and Australia have rejected  Massive dilution of the original targets to encourage countries such as Japan, Canada, NZ and Russia to ratify  Russia was the key country that will determined if the Protocol enters into force

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Kyoto-style Permit Trading  Emission permits are issued equal to the Annex 1 target  Each country receives an allocation of permits  Countries/firms buy permits if they wish to increase emissions sell permits if they wish to reduce emissions  Trading allows original country targets to be tightened or relaxed depending on the costs Abatement differs across countries depending on costs of abatement relative to the price of permits The permit price will be determined by demand and supply and will equal the cost of preventing the emission of an additional unit of carbon

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Advantages of Kyoto trading  Global target is met but differential country response allowed through the market  Cost of removing an additional unit of carbon is equal everywhere (efficient)  Compensation (across countries and within countries) can be built into the initial permit allocation

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 A fundamental problem with targets and timetables  What is the correct target for each country and the world?  What is the optimal period? targets impose unknown cost for given outcome for emissions  permit trading gives greater flexibility across countries but no flexibility in total Problems With Kyoto Approach

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 If costs are low we miss the opportunity to cut emissions quickly (in total) because we have a fixed target  If costs are high we might create severe problems that would destroy the commitment to Kyoto

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 Permit trading more widely implemented could cause economic and political problems with large wealth transfers between economies and large fluctuations in trade balances and real exchange rate  Some historical examples Dutch Disease – e.g. North Sea Oil Discovery in 1970s Keynes classic “transfer problem” related to German Reparations after WWI Problems With Kyoto Approach

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 If one large country reneges the permit system would likely collapse since the price depends on all countries supply and demand  This requires a very strong monitoring and enforcement mechanism in all participating countries.  If developing countries participate in permit trading the price of carbon would be the same as in industrial countries – why would they want this structural shock even with payments for permits? Problems With Kyoto Approach

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A carbon tax:  A fixed price for carbon with revenue going to the government  Emission outcome is unknown but the cost of carbon is known with certainty  Problems Tax payments are enormous If optimal reduction is 20% of emissions, firms must pay tax on 80% of original output. Very unpopular with industry and politicians!

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Subsidies for the Best Technology ?  Clean Coal?  Renewables?  Problem is that the solution will be technological but are governments the best placed to pick the winners? The subsidies will likely go to those with the greatest lobbying power

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Mandatory Targets for renewable energy  Evidence is that this is a high cost approach  Targets and timetables approach yet again

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Features  Released when carbonaceous fuels incompletely combust  Hard to measure  China is 17% of global emissions  Mostly emitted by burning of raw coal, coal briquettes and bio-fuels in the residential sector

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Source: Table 2 page 7 of Streets (2004)

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Are there any other alternatives to the standard economic instruments?  Need a policy with best features of permits, taxes and subsidies  Like a tax: Should guarantee that costs won’t be excessive  Like permits: Should avoid huge transfers to the government  Like subsidies: it should encourage the search for technological solutions  Importantly it should make property rights clear over a long period and provide incentives for industry,households and governments to reduce emissions at low cost

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The Blueprint (a hybrid policy)  Each participating country would: Require that producers of energy within their borders have an annual emission permit for each ton of carbon embodied in their energy produced and sold domestically or imported Issue long term emissions permits equal to a specified fraction of a base period emissions with declining emission if required. Be allowed to sell additional annual permits to firms within its borders at a stipulated price ($P per ton of carbon), where $P could be $US10 per ton of CO2. Create domestic markets in the long term and annual permits

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Long Term Permit Looking at the policy in more detail: z Allows one unit of emission per year for a long period z Distributed once at enactment z Can be leased or sold within a country z Quantity can set by treaty: Q T z Price will be set by the market Annual Permit z Allows one unit for one year z Sold by government as demanded z Price set by treaty: P T

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Supply of each type of permit (for use in a given year) $ S S Q P Annual permits for sale P T Long Term permits for lease SL SL $ Q P Q T

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Overall  Creates incentives for investment Raises the marginal cost of emissions into the future  Incentives are credible Built-in constituency of long term permit holders Robust to accessions and withdrawals Operates within existing institutions  Provides a foundation on which to build Completely consistent with technology policies Provides incentives for adoption and diffusion

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Expandable  Because it is a domestic system, other abatement activities can be included as a way to generate annual permits with the revenue going to these activities instead of the government

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Main Concept The long term permits are the medium term goals for emissions without a timetable of when they are reached The short term permits are the economic costs to the economy Move through a low cost path from the short run to the longer run in decadal steps with profit incentives to reduce emissions wherever cost effective

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A Partial Analogy – Bond markets Long term government bond market prices interest rates over long horizons given a stock of government debt (like long term permits) Central banks set the short term interest rate - the supply of financial liquidity is generated by the market (like annual permits). The long term interest rate (which is flexible) is the expected value of future of short term interest rates (which are fixed in any period)

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Encouraging Non Fossil Fuel Energy and carbon capture technologies Relative price of carbon higher in the short term and the longer term Clear pricing over long time periods gives a clear signal of the return to investment in non-fossil fuel energy sources or capture of carbon from fossil fuels Could allow non-fossil fuel energy producers and carbon capture to generate annual permits in proportion to the amount of carbon not emitted (does not require international negotiation while the price cap is binding)

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Is early action a good idea?  Australia could adopt the Blueprint today in advance of the rest of the world both for a direct economic gain and to encourage the rest of the world to adopt similar policies  Most models ignore uncertainty and therefore do not incorporate wealth generated from risk management

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What about competitiveness?  The cost of carbon is not the largest cost even in aluminium production – the cost of capital is more important  Under the Blueprint, the cost of carbon that affects direct competitiveness is controlled by the government and is kept low until other countries impose carbon prices in which case the competitiveness issue disappears over time  The increased ability to manage asset risk will be more positive for a company’s balance sheet than the negative effect of a slightly higher short term carbon price

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What about carbon leakage?  Why would a fossil fuel intensive industry move away from an economy in which the risk to their capital is hedged, into an economy with greater political risk and no carbon policy when you know that over the next decade or so carbon policy will be inevitable.  A small rise in the carbon price can be more than offset by the gains of risk reduction on protecting capital

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Early Action is critical  Australia should act now in creating markets with long term price signals that: That enable energy generators and energy intensive industries to protect their capital value against change in the climate and changes in climate policy Give clear profit signals to alternative generating technologies and other technologies such as carbon capture and storage

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Early Action is critical  R&D in only a partial but a necessary part of the solution but without a market price there is little incentive for technologies to be implemented and diffused through the economy

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Key Points  Each system is run within a country using that country’s own imperfect monitoring and enforcement mechanisms and its own legal and accounting systems  No international trade in the assets only domestic markets Short run efficiency guaranteed by a common price Long run efficiency driven by structural change  Incentives for all actors are internalized within countries

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Developing Countries...  Negotiate a perpetual permit allocation that is larger than current emissions  Price of annual emission permits zero in the short run because more permits than needed  Price of perpetual emission permits will be non zero giving important signals for investment projects  Over time the permit price in countries will equalize as developing countries “ability to pay rises”

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Developing Countries...  Will developing countries ever agree? Depends on who is expected to get the valuable assets called permits Will they ever agree to Kyoto style interventions?

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Advantages of the Blueprint policy  Guarantees that compliance costs would not be too high Passes the test that Kyoto fails  Can be justified on cost-benefit grounds Current knowledge about climate risks justifies slowing emissions at low cost

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Advantages of the Blueprint policy  Avoids huge transfers to the government Each government can decide how to hand out perpetual permits but once these property rights are distributed they are not revisited (like land contracts) Permits act as transition relief for industries (and affected workers) and will reduce opposition Also, easy for industry to understand -- like grandfathering  Reduces emissions wherever cost-effective Prudent: eliminates emissions where possible below a fixed price

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More advantages...  Maintains national sovereignty Important for US and developing country participation  Incorporates an explicit mechanism for developing country commitments with no short term costs but clear incentives for future investment in less carbon intensive activities  Provides a futures market (long term permit market) Allows individual risk management

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More advantages...  No direct international transfers of wealth Trading is national, rather than international Less disruptive to exchange rates and foreign aid budgets  Gives incentives for early action Perpetual permits could be distributed now, even without a treaty! The private sector is already doing this but property rights unclear

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More advantages...  Built-in incentives to monitor and enforce Annual permits generate government revenue Owners of perpetual permits do not want permit prices to erode  Credible Less draconian so more likely to be enforced into the future

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Still more advantages...  Relatively easy to modify as information arrives Can raise or lower the world price as risks become better known  Easy to add countries over time Does not require re-negotiation of treaty New countries don’t hurt existing permit owners  Creates a future market in carbon (the perpetual permit market) Gives a long term price signal but with a fixed short term cost

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An Illustration of how Uncertainty impacts on the costs of Kyoto versus Blueprint  Suppose Russia grows at 1% per year faster from 2000 to 2012 than our baseline forecast (4.4% rather than 3.3%)  What is the cost of Kyoto versus the Blueprint under the baseline scenario versus the alternative scenario of higher Russian growth?  Both Kyoto and the Blueprint assume non participation by developing countries even though the Blueprint has a clear mechanism for getting developing country participation!

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Where to go from here?  The current approach as embodied in the Kyoto protocol does not deal with uncertainty and is not sustainable  The Blueprint dominates in terms of the extent of emissions reductions; risk management; sustainability.  The Blueprint can be implemented within countries and is consistent with moving towards Kyoto if a country ever wanted to. Just have the government pull out of the annual permit market and allow these asset to be traded internationally